n March 2015 the management team of Londonderry Air (LA) met to discuss a propos
ID: 2753144 • Letter: N
Question
n March 2015 the management team of Londonderry Air (LA) met to discuss a proposal to purchase five shorthaul aircraft at a total cost of $25 million. There was general enthusiasm for the investment, and the new aircraft were expected to generate an annual cash flow of $4 million for 20 years. T he focus of the meeting was on how to finance the purchase. LA had $20 million in cash and marketable securities (see table), but Ed Johnson, the chief financial officer, pointed out that the company needed at least $10 million in cash to meet normal outflow and as a contingency reserve. This meant that there would be a cash deficiency of $15 million, which the firm would need to cover either by the sale of common stock or by additional borrowing. While admitting that the arguments were finely balanced, Mr. Johnson recommended an issue of stock. He pointed out that the airline industry was subject to wide swings in profits and the firm should be careful to avoid the risk of excessive borrowing. He estimated that in market value terms the long-term debt ratio was about 59% and that a further debt issue would raise the ratio to 62%. Mr. Johnson’s only doubt about making a stock issue was that investors might jump to the conclusion that management believed the stock was overpriced, in which case the announcement might prompt an unjustified selloff by investors. He stressed therefore that the company needed to explain carefully the reasons for the issue. Also, he suggested that demand for the issue would be enhanced if at the same time LA increased its dividend payment. This would provide a tangible indication of management’s confidence in the future. These arguments cut little ice with LA’s chief executive. “Ed,” she said, “I know that you’re the expert on all this, but everything you say flies in the face of common sense. Why should we want to sell more equity when our stock has fallen over the past year by nearly a fifth? Our stock is currently offering a dividend yield of 6.5%, which makes equity an expensive source of capital. Increasing the dividend would simply make it more expensive. What’s more, I don’t see the point of paying out more money to the stockholders at the same time that we are asking them for cash. If we hike the dividend, we will need to increase the amount of the stock issue; so we will just be paying the higher dividend out of the shareholders’ own pockets. You’re also ignoring the question of dilution. Our equity currently has a book value of $12 a share; it’s not playing fair by our existing shareholders if we now issue stock for around $10 a share. “ Look at the alternative. We can borrow today at 6%. We get a tax break on the interest, so the after-tax cost of borrowing is .65 × 6 = 3.9%. That’s about half the cost of equity. We expect to earn a return of 15% on these new aircraft. If we can raise money at 3.9% and invest it at 15%, that’s a good deal in my book. “ You finance guys are always talking about risk, but as long as we don’t go bankrupt, borrowing doesn’t add any risk at all. “ Ed, I don’t want to push my views on this—after all, you’re the expert. We don’t need to make a firm recommendation to the board until next month. In the meantime, why don’t you get one of your new business graduates to look at the whole issue of how we should finance the deal and what return we need to earn on these planes?” E valuate Mr. Johnson’s arguments about the stock issue and dividend payment as well as the reply of LA’s chief executive. Who is correct? What is the required rate of return on the new planes?
Balance Sheet
*The yield to maturity on LA debt is currently 6%
**LA has 10 million shares outstanding, with a market price of $10/share. LA's equity beta is estimated at 1.25, the market risk premium is 8% and the T-Bill rate is 3%
Financial Statement summaryBalance Sheet
(in Millions $) Bank Debt 50 Cash 20 other current liabilities 20 other current assets 20 10% bond, due 2032 100 fixed assets 250 stockholders' equity 120 Total Liabilities 290 Total Assets 290 Income Statement Gross Profit 57.5 Dividend 6.5 Depreciation 20 interest 7.5 pretax profit 30 tax 10.5 net profit 19.5Explanation / Answer
LA's chief Executive's arguments are very appropriate as the current position of the LA is in position where there is 10Mn required to mee the comapny's normal routine expenses & on top of that looking at the company's current debt equity ratio any further equity issues by the LA will be nothing but playing with the cash of stakeholders & out of which dividend will be paid. Further, correct point has been placed by Chief Executive of taking tax benefits & making the investments. Hence , in my views LA's chief executive's views are correct.
Required Rate of Retunrs on new planes:
Company's required rate of returns i.e. IRR internal rate of retunrs needs to be calculated where the total cash outflow on these planes will be equalised with inflows.
Therefore, upon making the calculation on pro-rata basis @ 15% the total present value from the project (at inflows of 400Mn) is 2503.7Mn$ and @16% the present vlaue of cash inflows is 2371.54Mn$ the difference of which is 132.16Mn$ upon increasing 1%. Now, to equalise inflows & outflows the difference is of 3.7Mn$ (2503.7 - 2500) and therefore by making the pro-rata calculation or cross multiplying 3.7Mn $ for 132.16Mn$, the increament of 0.03% is required to be adjusted to 15%, hence the required rate of returns on this project will be 15.003%.
Note: Here, the cash inflows have been considered before taxes as, taxes are paid for the entire company's operations and hence tax implications for this project is not taken.
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.